Drafting Tips

Subscribe to Drafting Tips

The Fox Rothschild associate team of Megan Center and Alex Radus recently gave a presentation at the International Franchise Expo in New York City on the “Top Ten Provisions to ‘Never’ Negotiate in a Franchise Agreement”. A summary of this presentation will be prepared in four separate blog posts. The first post focused on central themes of franchise negotiation, and the second post addressed protecting the confidentiality of franchise negotiations.

This installment details the first five of our top ten provisions to “never” negotiate.

1)           Signing “then-current” franchise agreement

  • Typical Provision: Upon transfer, renewal or purchase of an additional unit, the franchisee must sign the franchisor’s then-current form of franchise agreement.
  • Franchisee Argument: Franchisees want the same terms for the entire franchise relationship. Uncertainty increases investment risk and hinders growth.
  • Franchisor Argument: Franchisors spend time and money on continually developing and refining their form of franchise agreements. Franchisors need to rely on the uniform use and enforceability of their then-current franchise agreements. Franchisors cannot predict the future and, given that a renewal franchise agreement will be signed many years after the initial franchise agreement, franchisors need the flexibility to use their then-current form of franchise agreements at that time.
  • Compromise: Parties often agree not to change fees, territory and terms they initially negotiated. If any terms were negotiated due to the “newness” of the relationship, these generally lapse as the relationship matures.

2)           Reservation of Rights – Competitive Units or Brands

  • Typical Provision: Except for the franchisee’s right to operate in the territory, the franchisor reserves all other rights, including to open units in non-traditional venues (stadiums, shopping malls, etc.) and to operate competitive brands in the franchisee’s territory.
  • Franchisee Argument: Franchisees won’t want to compete with company units, which may have greater resources, preferred pricing from suppliers, and may not pay royalties. They may also seek locations near non-traditional venues to capitalize on that market.
  • Franchisor Argument: Franchisors are unable to predict every future business opportunity they may encounter and need flexibility for future growth. Franchisors cannot restrict the sale of the entire franchise system because one franchisee objects. Franchisors need to reach customers through every avenue possible, including non-traditional venues, which may increase brand exposure and visitation of a franchisee’s unit.
  • Compromise: Parties can mitigate competition risk by carving out venues near the franchisee’s location, or granting the franchisee a ROFR to purchase units in non-traditional venues.

3)           Right of First Refusal

  • Typical Provision: Except for the right to operate in the territory, the franchisee has no other rights to operate additional units (within or outside the territory).
  • Franchisee Argument: From the franchisee’s perspective, a right of first refusal (“ROFR”) to purchase additional units is optimal: if the investment is successful, the franchisee can double down, while avoiding the obligation to open additional units under a development agreement.
  • Franchisor Argument: Franchisors need to protect their right to make additional sales without having to check with franchisees. Franchisors will likely be starting out a relationship with a new franchisee and may be unsure as to whether this franchisee would be a good fit as a multi-unit owner.
  • Compromise: The parties can agree to a ROFR subject to certain stipulations. First, the ROFR should lapse if a franchisee refuses it more than a certain number of times. Second, the ROFR will only be available after the franchisee has been successfully operating a unit for a certain period of time. Lastly, it’s important to outline a process for how a franchisee can exercise this right, including a time period on the response.

4)           Marketing Fund

  • Typical Provision: The franchisee must contribute to a national marketing fund. The franchisor can spend the funds as it sees fit.
  • Franchisee Argument: Franchisees want assurances that marketing funds will be spent in their territories. They may also seek to limit the franchisor’s discretion via restrictions on the use of proceeds or oversight (including audits or formation of a franchisee advisory committee).
  • Franchisor Argument: Franchisors are in the best position to determine the most effective way to advertise the franchise system on a national basis. Franchisors need flexibility to promote the franchise systems, including ability to spend in any geographical region. The purpose of the marketing fund is to promote the brand on a national basis and the franchisee should focus its efforts on local advertising in its territory.
  • Compromise: If franchisors have an internal marketing team, they can offer franchisees additional marketing assistance free of charge. Alternatively, franchisors can waive a franchisee’s requirement to contribute to the marketing fund only after a certain number of units are open and operating. In exchange, the franchisee must expend the amount it would have contributed to the marketing fund on local advertising. That way, the funds are still being utilized to promote the brand.

5)           Renewal

  • Typical Provision: Franchisee has the right to renew the franchise agreement a limited number of times (1-2) if certain conditions are satisfied.
  • Franchisee Argument: Franchisees want unlimited renewals. They will argue that as long as they are in compliance with the franchise agreement, they should not lose their business, which is often a franchisee’s livelihood.
  • Franchisor Argument: Franchisors want to avoid creating an evergreen contract. An evergreen contract has an indefinite duration and is difficult to terminate. Franchisors need the ability to evaluate franchisees on a semi-regular basis to determine whether they are still a good fit for the franchise system.
  • Compromise: The parties may agree to longer renewal terms (e.g., one 10-year renewal term instead of two 5-year renewal terms). Clear renewal conditions and a cap on renewal costs will also help franchisees budget and prepare.

In the next installment, we’ll launch into the remaining top 10 provisions to “never” negotiate:

  1. Changing Marks/Renovations/Upgrades
  2. Termination/Cure Period
  3. Indemnification
  4. Assignment
  5. Personal Guaranty

The Fox Rothschild team of Megan Center and Alex Radus recently gave a presentation at the International Franchise Expo in New York City on the “Top Ten Provisions to ‘Never’ Negotiate in a Franchise Agreement.” A summary of this presentation is being presented in four separate blog posts.  The first post focused on the central theme of franchise negotiation from the perspective of the franchisor and franchisee.

This installment highlights a few practice pointers that can save time and money during the negotiation process and protect the confidentiality of your negotiations.  Installments three and four will examine the top ten things never to negotiate in in detail, including typical franchisee requests, franchisor counter-arguments, and common compromises.

When negotiating a franchise agreement, the franchisee should provide a memorandum of the terms he or she proposes to revise.  This can take many forms, from a formal letter of intent to an informal email.  The level of detail will vary, but at a minimum it should cover all of the franchisee’s requests and be thorough enough for the parties to begin negotiations and understand what they are agreeing to.  This process focuses the parties on the most impactful terms and identifies potential deal breakers early in the process, saving time and money.

Copyright: / 123RF Stock Photo

Once the negotiated terms are established, we suggest that they should preferably be included in an addendum to the franchise agreement, which will be attached to the franchisor’s standard form of franchise agreement.  We strongly encourage you to avoid revising the standard franchise agreement.  There are a few reasons for this.  First, it is generally easier and faster to draft and negotiate an addendum rather than redline the entire franchise agreement.  Second, sticking to an addendum will keep revisions focused and precise.  The franchisee’s attorney is likely to make more changes if he or she has the opportunity to redline the entire franchise agreement. Finally, when you need to review the negotiated terms of multiple franchise agreements, short addendums will be easier to review than redlined franchise agreements.

Finally, be sure to protect the confidentiality of your negotiations – but don’t go overboard.  Franchisees will talk to each other, which can be both good and bad.  You want your star franchisees to speak with new and prospective franchisees.  They’re in a great position to give advice that will boost performance, and to be a cheerleader for your system.  However, avoid permitting them to share negotiated terms, which can hurt morale and give new franchisees unreasonable expectations. For example, original or early franchisees may have obtain concessions that were appropriate for a startup system may no longer be appropriate at later stages of the brand’s development.  Moreover, you must be sure to understand the franchise laws of the states where you are offering franchises, which may require you to disclose negotiated terms in certain cases as briefly mentioned in our first post.  Also, as you probably know, disclosures and representations respecting financial performance are fraught with danger and should never be made by franchisees.

Your addendum should include a confidentiality provision that balances these considerations.  The negotiated terms, and the fact that you negotiated your franchise agreement, should be protected from disclosure.  After all, those are private terms between two business partners.  However, franchisors shouldn’t be so specific as to prevent franchisees from communicating in ways that benefit all members of the system.

In the next installment, we’ll launch into the first 5 of our top 10 provisions to “never” negotiate:

1.       Signing the “then-current” franchise agreement

2.       Reservation of Rights

3.       Right of First Refusal

4.       Marketing Fund

5.       Renewal

We, Megan Center and Alex Radus, recently gave a presentation at the International Franchise Expo in New York City on the “Top Ten Provisions to ‘Never’ Negotiate in a Franchise Agreement” and want to share the highlights of that presentation here.  This first of four blog posts will focus on central themes of franchise negotiation from the perspective of both the franchisor and franchisee.

With that, before we jump into the theme of negotiation, we want to briefly touch on the top ten provisions we will cover over the next few blog posts, which are as follows:

1.      “Then-current” form of Franchise Agreement

2.      Reservation of Rights

3.      Right of First Refusal

4.      Marketing Fund

5.      Renewal

6.      Changing Marks/Renovations/Upgrades

7.      Termination/Cure Period

8.      Indemnification

9.      Assignment

10.  Personal Guaranty

In each of the blog posts that follow, we will discuss the typical provision in a franchise agreement, the typical request by a franchisee, and how both a franchisee and franchisor may argue for its respective provision or revision.

By way of introduction, we want to briefly touch on why a franchisor may want to, or in certain circumstances be required to, negotiate provisions of its franchise agreement. First, economic factors may contribute to negotiation points. As the economy ebbs and flows, the sales of franchises often will follow. A franchisor may have to grant more concessions in a bad economy, or vice versa, in order to make a franchise sale.

Second, if an emerging brand, a franchisor may need to offer its original franchisees a more incentivized franchise package than an established franchisor would. Similarly, if a franchisor is trying to entice a multi-unit franchisee or a franchisee that has experience in operating other franchised businesses to join its franchise system, a franchisor may have to “sweeten the pot” and offer more concessions than it would a standard-single unit-franchisee.

Additionally, if a franchisor is expanding internationally, similarly to an emerging brand, a new franchisee will be developing the brand in an entirely different country, often with no brand recognition.  As such, it may need further incentives to take on this additional obligation.

Lastly, and perhaps most importantly, certain states require that a franchisor amend certain portions of its franchise agreement via a state law addendum. Generally, these changes relate to dispute resolution procedures, governing law, and termination procedures. Further, if you negotiate changes with franchisees in California, you are required to comply with the Negotiated Changes Law in California which mandates disclosure of all material revisions to the franchise documents granted to California franchisees to all California prospects for a year from the closing of the negotiated deal.

The next post in this series will focus on practice pointers if a franchisor chooses to, or is required to, negotiate a franchise agreement.

Almost every year at the IFA Annual Legal Symposium in Washington D.C., a panel of distinguished franchise attorneys and state regulators will discuss best practices in drafting a franchise disclosure document in compliance with the FTC Franchise Rule.   This year was no different and the workshop “Thorny FDD Disclosure Issues” offered a number of best practices and tips to help draft an FDD that is compliant with federal rule and state law and will breeze through the state registration process:

25388704 – know the rules
  1. Item 2 (Business Experience). Franchise systems often have a difficult time determining what officers to disclosure. The panelists reminded attendees that when making this decision, the franchisor should ask themselves whether “an individual’s involvement in either sales or operations is such that a franchisee would rely on his or her expertise, formulation of policy, or control of the system.”
  2. Item 3 (Litigation). Remember that the FTC Rule requires that all material terms to a settlement must be disclosed regardless of whether the settlement agreement is confidential. Legal counsel should remind franchise system clients of this fact so they are not surprised when state regulators demand the information be included in Item 3.
  3. Item 6 (Other Fees). Remember to distinguish between negotiated discounts in initial fees verses other fees. Item 5 requires disclosure of discounted initial fees during the last fiscal year but Item 6 does not require the disclosure of discounted royalty deals.
  4. Item 8 (Restrictions on Sources of Products and Services). Item 8 requires franchisors to disclose the precise basis by which a franchisor receives consideration for required purchases or leases made by the franchisees. State regulators interpret this as a requirement to specify a percentage or flat fee amount per item. For example, “franchisor receives a rebates of $300 for each oven purchased.”

With such resources as the FTC Compliance Guide, FTC Frequently Asked Questions and NASAA Disclosure Guidelines, it would seem like there should be nothing up for debate when it comes to FDD drafting.   After attending this workshop, however, it is clear that there are always new tips to learn.

 

The fight against joint employment of franchisors and franchisees took a small hit when the Western District of Pennsylvania (“Court”) chose to allow a franchisee’s employee’s suit to proceed. In Harris v. Midas, et. al., the plaintiff, Hannah Harris (“Harris”), convinced the Court that she had proffered enough evidence to allege a plausible basis to hold the franchisor (“Midas”) as a joint employer and vicariously liable for the franchisee’s conduct with respect to Harris’ sexual harassment claims against her franchisee employer.

In the instant case, the Court looked at three factors commonly employed to evaluate joint employer liability. First, the Court examined Midas’ authority to hire and fire employees, promulgate work rules and assignments and set conditions of employment. While the Court noted that Midas did not have the authority to hire or fire employees, the Court held that Midas could establish work policies. Specifically, the Court pointed to the provisions of the Franchise Agreement that require franchisees to comply with all lawful and reasonable policies imposed by Midas. Those policies specifically include those policies governing the training of personnel. Further, Harris noted that Midas provided guidance to its franchisees on the creation of its employee handbook and the inclusion of a sexual harassment policy, further exerting its control to influence these workplace policies.

Second, the Court held that while Midas did not exert control over the day-to-day supervision of employees, under the Franchise Agreement, Midas had the authority to do so. Notably, the Court cited Midas’ ability to require employees to attend additional training programs. Further, Midas trained the franchisee who, in turn, trained its employees on the Midas system. Lastly, the Court noted Midas’ ability to visit and inspect the franchisee’s location as further evidence of Midas’ potential influence over the day-to-day supervision of the franchisee’s employees. The Court’s reliance on these provisions is worrisome because many franchisors use similar language to protect the uniformity of the brand.

The last factor, Midas’ control over employee records, the Court again made a stretch to connect the dots. The Midas Franchise Agreement stated that Midas has the right to audit and examine the franchisee’s books and records, which, the Court held, could be interpreted to include personnel files if read as broadly as possible.

Furthermore, Harris argued that Midas was vicariously liable for the franchisee’s conduct because the franchisee was essentially acting as Midas’ agent. The Court agreed holding that the terms of the Franchise Agreement are so generally phrased as to provide Midas broad discretionary power to impose nearly any restriction or control it deems appropriate.

While the case at hand is at the initial phase and will likely be subject to further scrutiny, it demonstrates another avenue that courts are using to impose joint employer liability. Here, the Court is relying upon the broad and sweeping provisions of the Franchise Agreement that Midas is using to protect its brand and franchise system. The fine line franchisors must continue to tread between exerting just enough control to ensure proper maintenance of the franchise system but not enough to cause joint employer liability continues.

 

A recent decision in the United States District Court of Arizona (“Court”) could have far-reaching consequences to many franchisors based on the broad-sweeping principles the Court used in its reasoning. In Zounds Hearing Franchising, LLC et. al. v. Bower et. al., the Court answered the question of whether the Ohio Business Opportunity Purchasers Protection Act (BOPPA) trumps a choice of law and venue provision that provides for the application of law other than the State of Ohio.

Here, four franchisees filed suit against Zounds Hearing Franchising, LLC and Zounds Hearing, Inc. (collectively, “Zounds”) in the state court of Ohio for failure to comply with the five-day cancellation requirement under the BOPPA. Further, the aggrieved franchisees claim that Zounds made false, misleading and/or inconsistent representations than that contained in its FDD in connection with the sale of its franchises in violation of the BOPPA. Each Franchise Agreement provides that Arizona law governs the interpretation and enforcement of the Franchise Agreement and all disputes are subject to pre-suit mediation (at Zounds’ option) and venue in Arizona. As such, Zounds moved to remove the suits to Ohio federal court, which then transferred the suits to the instant Court.

In analyzing whether BOPPA should trump the provisions of the Franchise Agreement, the Court relied on the rules of the Restatement of Conflict of Laws. Specifically, the law of the state with the “most significant relationship” to the parties shall govern the agreement or, if the parties chose the law of another state, that state’s law shall govern. However, if the choice of law is contrary to a fundamental policy of the state with the most significant relationship, that state will presume to have the materially greater interest in its state law governing the agreement. In holding that Ohio has the most significant relationship to the parties, the Court noted that all of the franchises and franchisees were located in Ohio and it has a strong interest in protecting its residents, particularly where the underlying statute is designed to protect franchisees that are in an inferior bargaining position. Further, Arizona lacks a statute that protects purchasers of franchises, while BOPPA is directly on point to address the franchisees’ purported harm. Essentially, the franchisees would be left with little recourse against Zounds if Arizona law applied.

Further, the Court held that it is difficult to imagine that a statute that makes certain conduct a crime as being anything but the fundamental policy of the state. Additionally, the Ohio legislature amended the BOPPA in 2012 to explicitly state that any venue or choice of law provision that deprives an Ohio resident of protection thereunder is contrary to public policy, void and unenforceable further evidencing its intent. Lastly, the Court went so far as to say that even if a statute does not explicitly outline that it is fundamental policy of that state, a court still could deem it so by its very nature. Further, the lack of a non-waivability term does not doom the statute under this analysis. These principles may open the door to seemingly endless arguments about what constitutes the fundamental policy of a state.

As such, even though the parties agreed to the Arizona choice of law and venue provisions, the application of Arizona law would be contrary to the public policy of Ohio because Arizona does not have a statute that protects the rights of franchisee purchasers as does Ohio. Further, Ohio has a materially greater interest in the enforcement of its law because the franchisees are Ohio residents and the franchises are located therein.

In the alternative, Zounds filed a motion to compel mediation pursuant to the requirement for pre-suit mediation in Arizona in the Franchise Agreement. Here, the Court determined that the pre-suit mediation requirement violated the franchisees’ rights to Ohio venue because the mediation is “intimately bound up” with the franchisees’ right to sue under the BOPPA. Lastly, the Court determined that the mediations for all four franchisees could be joint despite the Franchise Agreement requiring that all proceedings arising out of the Franchise Agreement be decided on an individual basis. Here, the Court held that because pre-suit mediation was a “proceeding” (as argued by Zounds’ counsel), then the BOPPA prohibitions apply to the mediation requirement and the BOPPA specifically prohibits class action waivers. As such, the requirement to conduct pre-suit mediation was void in violation of the BOPPA. However, the parties conceded to conduct mediation during the course of the suit. As such, the Court required that the parties conduct joint pre-suit mediation. To take it a step further, the Court awarded the franchisees their attorneys’ fees because Zounds burdened the franchisees with a multiplicity of actions in a distant forum. Further, the Court cited the unequal provision in the Franchise Agreement that stated Zounds could recover attorneys’ fees upon a successful claim against a franchisee but did not afford franchisees with a reciprocal right. The Court noted that it would be a presumptive abuse of discretion not to award attorneys’ fees against an unsuccessful party who “used its superior bargaining position to impose such a term”.

Overall, this result could have substantial effects to any franchisor that currently has franchises in Ohio or has Arizona law as its choice of law. This decision suggests courts have wide latitude to determine whether another state has a substantial interest in the transaction and whether that state’s law should govern the agreement. Further, it is important to take note of the consequences this has on a franchisor’s ability to enforce non-binding mediation as a preliminary form of dispute resolution (and on an individual basis) and to collect attorneys’ fees (without a corresponding right afforded to the franchisee). Lastly, it would be prudent for all franchisors to review their franchise agreements in light of this decision.

A federal court in Colorado recently upheld a franchisor’s non-competition provision despite that state’s strong public policy against non-competes. The franchisor prevailed due to its thoughtful contract drafting and ability to effectively communicate the unique nature of franchising to the court.

In-home care franchisor Homewatch International, Inc. and its franchisee, Prominent Home Care, Inc., signed a franchise agreement that terminated on June 30, 2016. The next day, Prominent’s sole shareholder and officer (the “Defendant”), started a competing company. Homewatch sued the Defendant for breach of contract, seeking to enforce the non-competition provisions in their agreements.

The Defendant made two arguments in her defense (i) the franchise agreement’s non-competition provision did not bind her because she signed the franchise agreement only in her executive capacity on behalf of Prominent; and (ii) the non-competition provision was unenforceable under Colorado law.

Argument 1:  Parties Bound
The franchise agreement stated that, after the term of the franchise agreement, Prominent and its officers and shareholders could not own or operate a competing business within a twenty-five mile radius of a Homewatch location. Only Prominent (not the Defendant) signed the franchise agreement. However, the franchisor had also required the Defendant to sign a personal guaranty. The guaranty stated that the Defendant would be bound by the non-competition covenant in the franchise agreement.

The court ruled in the franchisor’s favor. It held that the guaranty unambiguously stated that the Defendant—in her individual capacity—would be bound by the franchise agreement’s non-competition provisions.

Argument 2:  Colorado Policy
Colorado law generally disfavors non-competition provisions. One exception to this rule is for a contract for the purchase and sale of a business. This exception promotes the purchase and sale of businesses by protecting the good will of the business being sold (i.e., a purchaser may be less likely to buy a business if it cannot obtain an enforceable non-compete from the prior owner).

Prior to Homewatch, the courts had not definitively decided whether the sale of a franchise qualified for this exception under Colorado law. The Defendant argued that the exception did not apply because the sale of a franchise is not a sale of a business—instead it is the sale of a license to the franchisor’s methods and intellectual property for a certain term.

The court rejected this argument, holding that the exception applied and the non-compete was enforceable. The court concluded that the “good will” rationale was just as important in the franchise context, noting that a significant portion of the value of a franchise system is its good will. (It should be noted, however, that Homewatch is a federal court opinion. A Colorado state court could come to a different conclusion; however, the state court would likely consider the Homewatch rationale in its decision.)

The Takeaways
Franchisors should take note of the Homewatch decision and ensure that their franchisees’ owners and key employees, especially those with access to confidential materials and training, sign non-competes in their individual capacities. This is often addressed in the personal guaranty, as it was in Homewatch. Franchise systems in states that frown upon non-competition provisions should be aware of the Homewatch rationale in the event they need to enforce their non-competes. Franchisors should also make sure to use experienced franchise counsel. In Homewatch, counsel was able to communicate the unique franchise model to the court and to persuasively argue why the court should apply a law that was probably not drafted with franchising in mind. The result was a win for the franchisor and also franchising, which relies on non-competes to mitigate risks inherent in the franchise model.

The intersection of franchise law and general corporate law is extensive. A recent decision in the Michigan Court of Appeals (Court) highlights the importance of thoroughly understanding and considering the ramifications of transactions involving both spheres of law.

In Retail Works Funding LLC v. Tubby’s Sub Shops Inc. and JB Development LLC, the plaintiff (Plaintiff) brought suit against each defendant (Tubby’s and JBD or collectively, the Defendants) after JBD purchased the rights and goodwill to the service mark JUST BAKED (Mark) from Just Baked Shop LLC (JBS). Prior to that, Plaintiff obtained a judgment against JBS for over $184,000.

In this suit, Plaintiff claims that JBD should be liable for Plaintiff’s judgment under a successor liability theory because JBD is a mere continuation of the Just Baked system by carrying Just Baked products in its stores and offering franchises. Further, Plaintiff argued that JBD held itself out to the public in news articles as having merged with JBS. Defendants argued that JBD only purchased the rights to one asset of the Just Baked business, the Mark, and did not agree to take on any its liabilities as supported by the language of the Service Mark Purchase Agreement.

As was the case here, when assets of a business are purchased with cash and not stock, the successor is generally not liable for the predecessor’s liabilities unless an exception to the rule applies. In holding for the Defendants, the Court determined that none of the three exceptions to successor liability argued by Plaintiff applied to the case at hand. First, the instant case did not constitute a “de facto merger” because JBD purchased the Mark for cash. Second, JBD was not a “mere continuation” of the former Just Baked business because Plaintiff failed to provide any evidence of common ownership between the entities or that JBD acquired substantially all of the assets of JBS. Lastly, the “continuity of enterprise” exception did not apply because judgment creditors cannot rely upon it. As such, the Court held that the Defendants were not liable for the judgment against JBS.

If the deal to purchase the Mark had been structured in a different way, there is a chance that the Defendants would have been held liable for the Plaintiff’s judgment against JBS. As such, a franchisor (and its counsel) must evaluate how a transaction will effect multiple areas of law and ensure adequate protection from adverse consequences in each area.

If a franchisor waives the non-compete provision in its current franchise agreement, can it enforce a non-compete when the franchise agreement is renewed? According to a recent decision by the 9th Circuit Court of Appeals, the answer is yes, and franchisors should consider a few key lessons from the decision. Robinson, DVM v. Charter Practices International, LLC, No. 15-35356 (June 21, 2017).

In Robinson, a franchisee sued its franchisor for breach of contract and other claims when the franchisor refused to renew their franchise agreement for a veterinary hospital franchise. During the term of the original franchise agreement, the franchisee owned and operated independent veterinary clinics that competed with the franchise. The franchisor did not enforce the non-competition provision in the original franchise agreement. However, when it came time for renewal, the franchisor notified the franchisee that it would enforce the non-compete under the renewal agreement and gave the franchisee an opportunity to disinvest from his independent clinics. The franchisee refused, and the parties did not renew the franchise agreement. The franchisee sued the franchisor alleging improper refusal to renew under Oregon law.

The district court dismissed the franchisee’s claims and the 9th Circuit affirmed. The court’s decision holds three important lessons:

  1. The renewal provision specifically allowed the franchisor not to renew the original franchise agreement unless the franchisee complied with the non-competition provision in the renewal agreement. Renewal provisions typically (and should) include general language requiring the franchisee to acknowledge it will be bound by the new franchise agreement. However, it is often wise to specifically reference sensitive provisions, including non-competes and other restrictive covenants and confidentiality provisions.
  2. The renewal provision in the original franchise agreement stated that the renewal agreement would be substantially similar to the franchisor’s then-current form of franchise agreement. It made clear that the terms could differ from the original franchise agreement. This language highlighted that the original agreement and renewal agreement were different contracts. The court used concluded that the waiver of the non-compete under the original franchise agreement did not carry over into the renewal agreement.
  3. The franchisor provided notice to the franchisee that it intended to enforce the non-competition provision, and it gave the franchisee an opportunity to disinvest. The franchisee argued that he and the franchisor had a “course of conduct” that permitted him to compete. According to the court, the franchisor’s notice disrupted this course of conduct, and therefore the waiver under the original franchise agreement did not apply to the new agreement.

Franchisors (especially emerging franchisors) may find it necessary to waive provisions in their form of franchise agreement to close the deal with a prospect. While this may make sound business sense at one point in time, it can chafe down the road. As Robinson shows, a carefully drafted renewal provision and notice may provide an escape hatch in certain situations.

Janitorial services franchisor Jan-Pro Franchising International, Inc. (“Jan-Pro”) is not the employer of its unit franchisees, according to a recent California federal court decision. Roman v. Jan-Pro Franchising Int’l, Inc., No. C 16-05961 WHA (N.D. Cal. May 24, 2017). The plaintiff franchisees failed to show that Jan-Pro exercised sufficient control over their day-to-day employment activities.

Copyright: stocksolutions / 123RF Stock Photo

What makes this case unique is that Jan-Pro operates a three-tiered franchising structure, often called a subfranchise arrangement. Under this arrangement, Jan-Pro grants subfranchise rights to a regional master franchisee (“Master Franchisee”), who is responsible for selling Jan-Pro unit franchises to individual franchisees (“Unit Franchisees”) in a particular geographic territory. The Unit Franchisees operate the franchised cleaning service business. Importantly, as is common in a subfranchise arrangement, Jan-Pro never directly contracts with its Unit Franchisees. Instead, Jan-Pro directly contracts with its Master Franchisees. Then, the Master Franchisees directly contract with the Unit Franchisees.

 

The plaintiff Unit Franchisees claimed that they were misclassified as independent contractors when they were really Jan-Pro’s employees. They sought minimum wages and overtime premiums from Jan-Pro. The plaintiffs argued that they were Jan-Pro’s employees under California law because the contracts between Jan-Pro and its Master Franchisees permitted Jan-Pro to control the business of the Master Franchisees and Unit Franchisees through its policies and procedures.

Under California law, “to employ” means

  1. To exercise control over the wages, hours or working conditions, or
  2. To suffer or permit to work, or
  3. To engage, thereby creating a common law employment relationship.

Martinez v. Combs, 49 Cal. 4th 35, 64 (2010). However, in the franchise context, controlling the “means and manner” of a franchisee’s operations is not sufficient to make a franchisor an employer. A franchisor is only an employer if it retains or assumes general control over employment matters such as hiring, direction, supervision, discipline and discharge. Patterson v. Domino’s Pizza, LLC, 60 Cal. 4th 474, 498 (2014).

The court concluded that Jan-Pro did not employ the Unit Franchisee’s employees. It reached this result despite the fact that the Master Franchisees exerted control over the Unit Franchisees under the contracts between them. Critical to the court’s analysis was the fact that these contracts did not confer any rights on Jan-Pro to control or terminate the Unit Franchisees. Nor was Jan-Pro a third party beneficiary of these agreements, which could give Jan-Pro the right to directly enforce them. Moreover, Jan-Pro never directly contracted with the Unit Franchisees.

The court’s analysis focused on features that are specific to subfranchise arrangements, especially the lack of a direct contractual relationship between Jan-Pro and its Unit Franchisees. A subfranchise arrangement is only one form of multi-unit arrangement, and is not appropriate for all franchise systems. Franchisors engaged in or considering this system should perhaps not put too much emphasis on the court’s analysis. For one thing, a franchisor may want to have some contractual rights it can enforce directly against Unit Franchisees. Additionally, even if Jan-Pro had directly contracted with Unit Franchisees, there appeared to be scant evidence that Jan-Pro controlled employment conditions in a manner that would make it a joint employer. However, if a franchisor were to indirectly control employment conditions through a subfranchise arrangement, a court might come to a different conclusion. In any event, the court’s decision was well reasoned and grounded in a firm understanding of franchising. It was certainly a win for the franchise model, made especially important by the fact that it took place in California, which is typically considered an employee and franchise friendly jurisdiction.